MBA 52i
Managerial Finance
Dr. Wael Moustafa
Lecture 1
Chapter 1
Overview of Financial Management and the Financial Environment
Finance is the Art and Science of managing money
On a personal perspective:
At the Corporate (Business) level:
-Finance is concerned with an individual’s
decisions regarding:
-Involves the same types of decisions
1) How firm raise money from investors.
2) How firm invest money in an attempt to
earn a profit.
3) How they decide whether to re-invest
profit in the business or distribute it back to
investors.
1) How much of their earnings they spend.
2) How much they save.
3) How they invest their savings.
Balance Sheet
tells us the financial position of a Company (firm) at a specific point of time (date)
Assets
Investing
Decisions
-Cash
-A/R
-Supplies
-Pre-Paid Expenses
-Inventory
-Marketing securities e.g. Treasury bills
*Current liabilities (short term Debt)
(Obligations to be paid within 1 year)
-A/P
-Accruals payable (Salaries/ finance
payable)
*Long term Debt
-Loans from Banks (Financial institutions).
-Corporate Bonds (long term debt
instrument issued by large corporation or
Government )
*Non-current Assets (Revenue
generator)
1-Tangible assets e.g.
-Land
-Equipment
-Building (e.g. ESLSCA)
2- Intangible assets e.g.
Goodwill-brand name -patency
*Stockholder’s Equity
-Common stock
-Preferred Stock
-R/E (retained earnings)
(undistributed profit reinvest Profit in the
business) +
Financing Decisions
Uses of Funds (money)
converted into Cash within 1 accounting
period)
Sources of Funds (money)
(What the company owns)
*Current Assets (Assets that Can be
Liabilities & Stockholder’s Equity
Stockholder’s equity: what the company owes to the owner ‫دى فلوس األونرز‬... ‫دى مش فلوس الشركة‬
Long Term Debt: what the company owes to the creditor
Marketing securities:
-Financial instruments that are very liquid & can be quickly converted into cash at reasonable price as
its maturity is less than 1 year e.g. treasury bills
Treasury bills:
Short term debt instruments issued by the government
Corporate Bonds
Corporate
Government
Bond Issued
Bond (Piece of paper),
they will share face value
1000 L.E
-Maturity Date: 10 years
Return: Coupon Interest Rate (10%) is
fixed annual interest paid by issuer to
bond holder
Investors
Bond Holder
(Creditor)
‫سلف الشركة‬
Idea of the bond: instead of borrowing money from the bank, will borrow it from investors
-It is a contract (Piece of paper) between the Bond issuer (Corporate & Government) and the Bond
Holder (Investors)
-Bonds & Stocks can be tradable
Timeline
0
1000
Each year he will pay 10% (i.e. 100 L.E)
If market interest rate is lower than coupon interest rate (bond is sold at premium)
If market interest rate is higher than coupon interest rate (bond is sold at discount)
Stock is type of security that signifies ownership in a corporation (by dividing ownership into shares)
2 types of Stock:
Common Stock)‫(األسهم العادية‬
- Owner takes variable dividends according to
firm performance & Board director decisions
(B.O.D)
-Have Voting rights.
-Subordinated in case of liquidation or income
distribution
Preferred Stock )‫(األسهم الممتازة‬
-Owners Take fixed dividends ‫توزيع أرباح ثابت‬
-Have no voting rights.
-Senior in case of liquidation or income
distribution ‫ بياخدوا فلوسهم األول‬:‫فى حالة تصفية الشركة‬
Return to stockholder is dividend distributed from profits or capital gain (‫(زيادة سعر السهم‬
-If I am stock → my return will be Dividends or Capital gain )‫(سعر السهم يزيد‬
-But if I’m Bond holder → my return will be Coupon Interest Rate (Fixed Interest Rate)
-Financial Manager’s first task in any company is to manage the networking (working) capital i.e.: to
balance between current assets & current liabilities.
-Networking Capital (the difference between Current Assets & Current Liabilities)
-Networking Capital = C.A-C.L >0
-If networking Capital is –ve → No liquidity
-If C.L > C.A → Cancer Case as it will eat from the part that generate revenue.
Financial Manager’s second task is investment decision
Financial Manager’s third task is financing decision including long term debts(loans or bonds) &
stockholder equity(C.s / P.S / R/E)
Decisions taken by Financial Manager:
1) Financing Decisions)
2) Investing Decisions
3) Managing Networking Capital
Income statement
What is Finance?
Finance is concerned with the process, institutions (Banks), markets(EgX) and instruments (CDs &
Stocks) involved in the transfer of money among and between individuals, business & governments
Financial System
(its main task is to transfer the money among and between
these groups through financial system)
Supplier of fund
Financial System
(Savers)
Individuals
Business
Governments
Financial Institutions or
intermediaries
e.g. Commercial Banks
(Indirect Finance: Supplier
doesn’t know the demander)
Financial Markets
(Direct Finance)
suppliers know borrowers
Demander of fund
(borrowers)
Individuals
Business
Governments
Certificate of Deposit (CD): is a financial instrument ‫شهادات األستثمار‬
Spread: is the difference between loan Interest rate & market Interest, i.e. so here he has spread (3%)
Investment Banks are related to creation of capital for companies, government & other entities for
example it aids in sales of securities.
Securities:
Financial instruments that hold some type of monetary value
*represents ownership position in publicly-traded corporation (via stock)
*represents creditor relationship with governmental body or corporation (represented by owing that
entity’s bond
Bank has two main sources of revenue:
*Loans
*Investment securities that can provide banks with a source of liquidity when they are sold.
Financial markets and financial intermediaries facilitate the flow of funds from savers to
borrowers.
Financial management involves the efficient use of financial resources in the production of
goods.
Finance goal …… make better personal finance decisions
Financial market
To Start up a new Business: (e.g. Cupcake Project)
Family &
Friends
Crowd Finance
Angel
Capital
Cairo Angels
Investment Bank
Venture
Capital
IPO (Initial
Public Offering)
Ideavelopers & Citadel
*Start-up business couldn’t take Bank loan because he doesn’t have Assets nor Records (History)
* Ideavelopers: it is considered as both Angel Capital & Venture Capital (they support the business)
Accounting
Major Areas & Opportunities in Finance
1. Financial service: concerned with the design and delivery of advice and financial products to
individuals, business & government found as Financial analysis and Financial advisor
Career opportunities include banking, personal financial planning, investments, real estate, and
insurance.
2. Managerial finance: is concerned with the duties of the financial manager working in a business.
Financial managers administer the financial affairs of all types of businesses—private and public, large
and small, profit-seeking and not-for-profit.
They perform such varied tasks as:
-developing a financial plan or budget.
-extending credit to customers.
-evaluating proposed large expenditures, and
-raising money to fund the firm’s operations.
2/10, n/30 (2% discount if you paid within 10 days & the full payment within 30 days with 0 discount)
It is set by financial manager to pay Long term liabilities.
Lecture 2
What’s our concern is Managerial finance or financial management which is the duties of the CFO (Chief
Financial officer), …they perform a financial plan or Capital budget.
Career Opportunities in Finance: Managerial Finance:
(Importance of finance after global financial crisis)
The recent global financial crisis and subsequent responses by governmental regulators,
1) increased global competition, and
2) rapid technological change also
3) increase the importance and complexity of the financial manager’s duties.
i.e. we are taking into consideration different types of risk in order to take our financial
decision.
i.e. instead of taking the firm specific risk, taking external risk by the foreign exchange risk e.g.
country risk I’ve to take into consideration while taking financial decision in order to increase
the value of the firm. How to increase the value of the firm?
There are 3 Major Questions that any financial manager should answer?
1) How much short - term cash flow does a company need to pay its bills? (Managing the
networking capital)
2) How the firm can raise the money for the required investments? (Making Financing decision)
3) What long - term investments should the firm engage in? (Making Investing Decision)
**Raising money wither from Debt or Equity
To create value, the financial manager should:
-Try to make smart investment decisions
(Determine the mix and type of assets found on the left - hand side of a firm balance sheet)
-Try to make smart financing decisions (i.e. by trying to reduce the cost of the capital by either
debt or issuing stocks, or using your R/E )
( Deal with right - hand side of a firm balance sheet)
--After raising the fund, you should find a way to generate the maximum revenue, so you’ve to
take smart investment decisions & smart financing decisions.
Legal Forms of Business Organization
Sole proprietorship
(owned by only 1 owner)
Family &
Friends
Corporation
Partnership
Angel
Capital
Sole proprietorship
A business owned by one
person and operated for his
or her own profit
Investment Bank
Venture
Capital
Partnership
Corporation
A business owned by two or
more people and operated
for profit.
-It has 2 types:
1) General partnership
(unlimited liability): In case of
bankruptcy or liquidation ‫هو‬
‫اللى بيشيل الليلة‬
-He makes the day to day
activity as well as decisions.
-In case of liquidation, all the
loans are their
responsibilities
-It is dividing the ownership
into shares (Common Shares
& Preferred Shares)
- Is a legal entity separate
from its owners and
managers.
-File papers of incorporation
with state.
-Charter.
- Bylaws.
- Owners have limited
liability which guarantees
that they cannot lose more
than they invested.
- Can achieve large size
through sale of stock.
- Subject to greater
government regulation
2) limited (Silent)
partnership(limited liability):
the maximum lose could be
what he has invested.
-He will lose only his capital
under liquidation
Disadvantage:
1) unlimited liability (i.e. in
case of bankruptcy ‫ ;افالس‬ppl
will take discount from the
fund)
- allowing the owner’s total
wealth to be taken to satisfy
creditors
2) Limited sources of finance
‫الفلوس معايا غير لما يكون معايا‬
‫شركة‬
3) Difficult to raise capital to
support growth
Corporation
Advantage:
1) Ease of formation.
2) Subject to few regulations
3) No corporate income taxes
(i.e. personal taxes & not
corporate taxes).
Example: majority are found
in the wholesale, retail,
service and construction
industry.
Corporate Organization
All Accounting
Activities
All Financing
Activities
Forecasting for the
future (for the
expected cash flow)
Limited Liability Organization
Limited Liability Corporation (Company)
A limited liability company (LLC) is a type of business entity formed that can be taxed like a
partnership but protects its shareholders from liability beyond their investment .
How it works/Example?
-Investors can decide to set up any type of legal business structure they like. However, if they
want to protect themselves from additional liability beyond their own investment, a LLC is a
likely choice. Some of the other major attributes of this type of business entity also include
more flexible management style and fewer formalities required by state law.
-Owners of a LLC are referred to as members. Once members decide on a LLC, they should file
an operating agreement with the state that defines how the LLC will be run, how members are
obligated financially, and how the profits and losses are to be allocated.
**Shareholders = Corporation
**Members = LLC (Limited Liability Corporation)
Managerial Finance Function
• Managerial finance function depends on the size of the firm.
• In small firms, the finance function is generally performed by the accounting department
(finance + Accounting) with each other in the same department.
• As a firm grows, the finance function typically evolves into a separate department linked
directly to the company president or CEO through the chief financial officer (CFO).
• Treasurer: (the firm’s chief financial manager) is responsible for the firm’s financial activities
such as financial planning and fund raising.
• Controller: (the firm’s chief accountant) is responsible for the firm’s accounting activities, such
as cost accounting.
Relationship to Economics:
-The field of finance is closely related to economics.
-The primary economic principle used in managerial finance is Marginal Analysis.
Marginal Analysis: (Added Benefit)
-Economic principle that states that financial decision should be made & actions taken only when
added benefit exceeds the added costs.
Example on relationship between Economics & Finance
A company is evaluating a decision to buy a new production line that requires an immediate cash
investment of $ 5M. This production line will have a useful life of 5 years. The net cash flow during this
useful life had been estimated and it has a net present value of $ 8M. The company has an existing
production line that may be sold today for $ 1M. It is expected that the existing production line has 3
years left in its useful life; the net cash flow during these 3 years are estimated & its NPV $ 3M.
➢ Cost of new product line 5M$
➢ Proceed from Selling old production
line 1M$
➢ Added (Marginal) Cost 4M$
Added (Marginal) Benefit 5M$
Net Benefit = 5M$ - 4M$ = 1M$
➔ Do buy the new machine
➢ Expected benefit of new production line 8M$.
➢ Benefit of old production line 3M$
➢ Added (Marginal) Benefit 5M$
>
Added (Marginal) Cost 4M$
Relationship Between Accounting & Finance
Finance
Accounting
Future
Take the financial decision
Current Market Value
Cash basis
(recognizes revenues & expenses only with
respect to actual inflows & outflow of cash)
Past
Record financial transaction
Historical Cost
Accrual Basis
‫بسجل‬
(recognizes revenues at the point of sale &
recognizes expenses when incurred (A/R & A/P)
Relationship to Accounting:
Accountants: devote most of their attention to the collection and presentation of financial
data.
Financial managers: evaluate the accounting statements, develop additional data, and make
decisions on the basis of their assessment of the associated returns and risks.
Example:
ABC company had sales account of $1 M during last year; out of which 60% is cash. The cost of
good sold is $800,000 out of which 80% is cash Required:
a) What is the accounting net profit or loss for the company?
b) What is the Net Cash Flow for the company?
a) Net Accounting (Accrual basis) Profit= Sales Revenue – COGS
1M$ - 800,000$ =200,000 $ (profit)
60%
b) Net Cash flow =
80%
Cash inflow – Cash outflow
600,000$ - 640,000$ = (40,000$) → Deficit
Example:
The following data is extracted from XYZ company for the last quarter of 2003
Oct.
Nov.
Dec
Sales
$1 M
800,000 $1 M
(-) Exp. 800,000 800,000 700,000
The company policy is to sell 40% cash, and the rest is on credit to be collected after 2 months.
The expenses are paid 70% cash, and the rest is after 1 month. Calculate the NCF during
December
Cash inflow
60% after 2 month
before
40% in the same month
Cash inflow (Dec.)
=40% of Dec. Sales
+60% of Oct. Sales
i.e. 40% x 1M
+60% x 1M
1M
Cash outflow
30% after 1 month
70% in the same month
Cash outflow (Dec.)
=70% of Dec. expe.
+30% of Nov. expe.
i.e. 70% x 700
+30% x 800
730,000$
Net Cash flow (NCF) of December = 1M – 730,000 = 270,000$
How to measure the profitability of any firm?
by Earning per Share (EPS)
Income Statement (Accrual basis & not Cash)
Sales Revenue
(-) C.O.G.S
Gross Profit
(-) Operating Expens.
EBIT
XX
(XX)
XX
(XX)
Business Risk:
e.g. ‫مطعم فى الساحل الشمالى‬
the firm inability to generate
enough dollar sales to cover its
C.O.G.S & Operating expenses
XX
(Earnings before Interest & Taxes)
(-) Investing Expense.
EBT
(-) Taxes
EAT
(-) P.S dividends
(XX)
XX
XX
XX
(XX)
Earning Available
for common stock
XX
90,000
Firm Specific Risk
Financial Risk:
the firm inability to generate
enough dollar sales to cover
financial obligations (Interest to
creditors, taxes to government &
P.S dividends)
**Investing Expenses: which pays to creditors
Stocks
Authorized Shares
(legal Shares)
i.e. legal number of
shares to be issued
100,000 Shares
Issued Shares
Outstanding Shares
Actual no. of shares
tradable
40,000 Shares
Re-purchased
10,000 shares from
Treasury Stock
30,000 Shares
Profitability per share (owner) is Calculated by EPS (Earning per share)
E.P.S =
Earning available for C.S
Number of Shares outstanding
= 90,000
= 3$ per share
‫مش ثمن السهم – لكن كا أونر‬
‫ نصيبه من المكسب بتاعى‬3$
30,000
as you increase the treasure, the equity decreases
Outstanding = Issued – Treasury so if the issued =0 so Outstanding =Treasury
EPS (3$)
B.O.D meet and decide
20% payout ratio
dividends / share
i.e. 0.6$ per share
80% R/E
Retention Ratio
‫المحتجزة‬
-Which means that 20% of the
EPS will be distributed as
dividends.
-10% of the 20% is distributed
as dividends to workers.
As Retention ratio
increases this means that
the firm has high GR
Substantial GR= Retention Ratio x R.O.E
Goal of a firm:
-Corporations commonly measure profits in terms of Earnings per share (EPS)
-Maximizing profit ; is it a correct goal???? NO
Profit maximization ignores
Cash available for C.S
Time Value of money
Risk
Because they are not cash,
they are accrual basis
Profit maximization may not lead to the highest possible share price for at least three reasons:
1. Profits do not necessarily result in cash flows available to stockholders
2. Timing is important—the receipt of funds sooner rather than later is preferred
3. Profit maximization fails to account for risk
1)Ignores cash flow available for stockholders:
-Profits do not necessarily result in cash flow available to the stockholders.
-Owners receive cash flow in the form of: cash dividends & capital gain .
-High EPS do not necessarily mean that B.O.D will vote to increase dividends payments.
-High EPS do not necessarily translate into a higher stock price; only when earnings increases
are accompanied by increased future cash flows would a higher stock price be expected.
(example: firm sold a high-quality product= increase in earnings due to reducing it equipment
maintenance expenditures=expenses decrease ---- profits increased BUT product quality
decreased = losing competitive position; therefore, stock price drops due to recognition of
LOWER FUTUR CASH FLOWS
2) Profit maximization doesn't consider the timing of return ( time value of money)
The receipt of funds sooner rather than later is preferred ( the larger returns in year 1 could be
reinvested to provide greater future earnings)
Which Investment is Preferred? (the sooner, the better) ‫كل ما تاخد فلوسك يبقى أحسن‬
3) Risk is also not considered
Risk: it means variation of the expected return from the actual return
-- tradeoff between return ( cash flow) & risk
- Cash flow & Risk affect share price differently :
*HIGH CASH FLOW LEAD TO HIGH SHARE PRICE.
*HIGH RISK LEAD TO LOWER SHARE PRICE ( ex. Death of highly successful CEO)
*In general , Stockholders are Risk - averse
→ Therefore; The goal of the firm is TO MAXIMIZE THE WEALTH OF THE OWNERS
*The wealth of corporate owners is measured by share price of the stock
(by increasing the expected Cash flow)
*Financial managers should accept only those actions that are expected to increase share price
Lecture 3
Individual versus Institutional Investors
Individual investors: are investors who purchase relatively small quantities of shares in order to
earn a return on idle funds, build a source of retirement income, or provide financial security.
Institutional investors: are investment professionals who are paid to manage other people’s
money.
-Institutional investors are more beneficial than individual investors because they have more
money. They hold and trade large quantities of securities for individuals, businesses, and
governments and tend to have a much greater impact on corporate governance.‫حوكمة الشركات‬
Governance and Agency:
-Corporate Governance
• Corporate governance refers to the rules, processes, and laws by which companies are
operated, controlled, and regulated.
• It defines the rights and responsibilities of the corporate participants such as the
shareholders, board of directors, officers and managers, and other stakeholders, as well as the
rules and procedures for making corporate decisions.
-The Agency issue
Principle
Agent
Corporation
(Managers)
# Conflict
(Agency Problem)
Main goal is to maximize profit
Shareholders
(Owners)
Main goal is wealth maximization
How to resolve the conflict between Managers & Owners?
-let the managers take performance share to be shareholders (owners) so instead of giving him
profit, give him performance share.
→ Drawback of performance share → External factors affecting it like Revolution
-A principal-agent relationship is an arrangement in which an agent acts on the behalf of a
principal. For example, shareholders of a company (principals) elect management (agents) to
act on their behalf.
-Agency problems arise when managers place personal goals ahead of the goals of
shareholders.
- Agency costs arise from agency problems that are borne by shareholders and represent a loss
of shareholder wealth. (in order to resolve the agency problem)
Financial Institutions & Markets:
Financial institutions an intermediary that channels the saving of individual , business &
government into loans or investment.
-The major financial institutions are commercial banks, investment banks & insurance
companies.
-The key supplier and demanders of fund in financial institutions are:
→ individuals------ net supplier of funds (save more than borrow).
→ Business firm--- net demander of funds.
→ Government------net demander of funds
**Sources of money for any bank are deposits
- In Egypt we’ve 3 types of deposits (current deposits, Ceiling deposit, CDs) and on the other
hand, it gets loans and investment securities.
-There is LTD (Loan to deposit ratio): percentage of loans to deposits (before the revolution it
was 53%)
Assets
liabilities
Loans &
Deposits
institutional (i.e. 100)
securities
So if the deposit 100$; automatically 10%
will be legal reserve according to CBE
(Central Bank of Egypt)
Commercial Banks, Investment Banks, and the Shadow Banking System
• Commercial banks are institutions that provide savers with a secure place to invest their
funds and that offer loans to individual and business borrowers.
• Investment banks are institutions that assist companies in raising capital, advise firms on
major transactions such as mergers or financial restructurings, and engage in trading and
market making activities.
Financial Institution
Commercial
Banks
Investment
Banks
Financial Markets
Spot Market
(Stock Market)
Derivative
market
(Future Market)
Forward Market
Future Market
Option Market
Financial Market (Spot Market)
Divided According to maturity
Money Market
For short term funds (< 1 year)
e.g. 1) Treasury bills
(Short term debt instrument issued by the
government)
Capital Market
For long term funds
e.g. 1) Stocks (Stock market)
(P.S & C.S)
2) Commercial paper (not in Egypt)
(Short term debt instrument issued by large
corporations)
2) Bond Market (Corporate bond)
Financial markets: provide a forum in which supplier of funds and demanders of funds can
transact business directly.
The two key financial markets :
-Money market ( for short - term fund )
-Capital market ( for long - term fund )
1 )The Money Market:
a financial relationship created between supplier & demanders of short - term funds.
-Most money market transactions are made in marketable securities i.e. can be liquidated
easily ( short – term debt instrument such as government treasury bills and commercial paper)
**In Egypt, there are three types of T-Bills i.e. 91 days, 182 days and 364 days.
For any firm to raise money, firms can use either private placement or public offering
Private placement:
the sale of a new security issue, typically bonds or preferred stock, directly to an investor or
group of investors such as insurance companies & pension funds
Public offering: (IPO)
the nonexclusive sale of either bonds or stocks to general public
Primary market: financial markets in which securities are initially issued.‫لما اروح اشترى عربية من المعرض‬
-The only market in which the issuer is directly involved in the transaction. E.g. IPO
-This is done through an intermediate named investment bank
Secondary market: financial markets in which pre - owned securities ( those that are not new
issues) are traded.‫سوق التالت أو سوق الجمعة‬
-The intermediate is the stock market. ‫اشتريت السهم من ال‬IPO ‫و بيبعهولك‬
-Example: NASDAQ or New York stock exchange and EGX
Types of securities
Equity(my money)
Capital
Shares
( both represent the owned capital & they have
no maturity )
C.S.:
Take variable dividends depend on:
1)The amount of net earnings.
2)The decision to distribute or to retain the
earning.
Have the right to vote (every share=one vote)
P.S.:
Take fixed dividends before common stock
1) Preferred stock are bought for the benefit of
its low risk as it has a fixed dividends regardless
of
- Amount of net earning
- The decision of distributing or retaining earnings
*Interest: is an expense
Debt(borrowed)
Long –term debts
Bonds
Bondholders:
1)Take interest on the par value of the bond 2)
Has a maturity date
The shareholder’s:
claim on firm value is the residual amount that
remains after the debt holders are paid
*Dividends: is paid only when there is net earning
Chapter 5
Time Value of money
To identify the Cash flow pattern of any company
Annuities
(Equal stream of cash flow)
Single Cash Flow
(Cash in & out)
Mixed Stream of Cash flow
(Unequal stream of cash flow)
Ordinary Annuity
Annuity Due
Perpetuity
e.g.
-Salaries.
-Payment at the
end of each year
e.g.
-Rent
-Payment at the
beginning of
each year
n=∞
‫دفع مدى الحياة‬
-Payment
amount of cash
flow
Interest Rate
Cost of borrowing money or Cost of return in case of lending money
Simple IR
Compounding IR
1 100 10% 110
2 100 10% 120
3 100 10% 130
1 100 10% 110
2 110 10% 120
3 120 10% 131.1
(You’re taking interest on
Interest)
(you’re not taking interest on interest
but you’re taking interest on principle)
Single Cash flow
0
Deposit
Timeline Value of money
Compounding IR i=10%
n=1 No. of compounding periods 1
110
100
Future Value of a
single C.F
(FV)
Present Value of a
single C.F
(PV)
Compounding process (moving forward)
110 = 100 + 100 x 10%
FV = PV + PV x i
Future Value of a single C.F
FV = PV x (1 + i)n
Future Value Interest Factor (FVIF)→ (1 + i)n
Whenever i or n inc. → F.V inc.
0
Discounting IR or Opportunity Cost Rate
i=20%
4
n=4
100,000
??
Future Value of a
single C.F
(FV)
Present Value of a
single C.F
(PV)
Discounting process (moving backward)
FV = PV x (1 + i)n
PV = FV x 1/(1 + i)n
Present Value of a single C.F
=100,000 x PVIF 20%, 4
Present Value Interest Factor (PVIF)→ 1/(1 + i) n
Table A-3
Whenever i or n inc. →P.V dec..
=100,000 x 0.4823 = 48,230 $
If N is not given
0
i=20%
100
??
n=??
FV = PV x (1 + i)
200
n
200 = 100 x (1 + 0.1)
200/100 = 1.1 n
n
2 = 1.1 n
Ln (2) = n Ln (1.1)
n = Ln (2)/ Ln (1.1)
N = 7 years
If i is not given
0
i=??
100
‫ فى الجدول‬2 ‫بدور على‬
4
n=4
FV = PV x (1 + i)n
200 = 100 x (1 + i)
2 = (1 + i) 4
200
4
∜ 2 = (1 + i)
1.18 = 1 + i
i = 0.18 x 100 = 18%
Lecture 4
Annuities
(Equal stream of cash flows)
Ordinary Annuity
Annuity Due
e.g.
-Salaries.
-Payment at the end of each year
e.g.
-Rent
-Payment at the beginning of each year
Period
Cash flow
1
100
2
100
3
100
Required: Calculate the F.V of Annuities (Ordinary & Due) with i=10%
0
1
2
3
100
100
100
0
1
2
100
100
100
F.V = 100 x (1 + 0.1) 0= 100
3
F.V = 100 x (1 + 0.1) 1= 110
F.V = 100 x (1 + 0.1) 1= 110
F.V = 100 x (1 + 0.1) 2= 121
F.V = 100 x (1 + 0.1) 2 = 121
F.V = 100 x (1 + 0.1) 3 = 133.1
N=2
N=3
F.V.A ordinary = 100 + 110 + 121 = 331 $
(Future Value of ordinary Annuities)
F.V.A Due = 110 + 121 + 133.1= 364.1 $
(Future Value of Annuity Due)
F.V.A ordinary = PMT x FVIFA i% , n
=100 x FVIFA 10%, 3
F.V.A Due = F.V.A ordinary x (1 + i)
= 331 x (1 + 0.1) = 364.1$
= 100 x 3.31 = 331$
0
1
2
100
100
3
0
100
1
2
100
100
P.V = 100/(1+0.1)0
P.V =
100/(1+0.1)1
P.V = 100/(1+0.1)2
P.V = 100/(1+0.1)3
P.V.A ordinary = PMT x PVIFA i% , n
P.V = 100/(1+0.1)1
P.V = 100/(1+0.1)2
P.V.A Due = P.V.A ordinary x (1 + i)
= 100 x PVIFA 10%, 3 =100 x 2.486 = 248.6$
-The Annuity Due is always greater than Ordinary Annuity whatever we are discounting or
compounding.
-The difference between Due & Annuity → 1 more interest for Due
3
100
Perpetuity Annuity:
0
1
??
1000
i=10%
2
n=∞
1000
P.V perpetuity = PMT/i
‫ جنيه مدى الحياة‬1000 ‫احط كام دلوقتى علشان تطلعلى كل سنة‬
=1000/10% = 10,000
All Laws
1) Future Value of a single C.F
Equation
FV = PV x (1 + i) n
Table A-1
FV = PV x FVIF i%, n
(i) is compounding rate or inflation rate
2) Present Value of a single C.F
Equation
PV = FV x 1/ (1 + i) n
Table A-3
PV = FV x PVIF i%, n
(i) is discounting rate or Opportunity cost
3) Future Value of Ordinary Annuity
Table A-2
F.V.A ordinary = PMT x FVIFA i%, n
4) Future Value of Annuity Due
F.V.A Due = F.V.A ordinary x (1 + i)
5) Present Value of Ordinary Annuity
Table A-4
P.V.A ordinary = PMT x PVIFA i%, n
6) Present Value of Annuity Due
P.V.A Due = P.V.A ordinary x (1 + i)
7) Present Value of Perpetuity Annuity
P.V perpetuity = PMT/i
n=∞
Equation
0
5
i=??
10,200$
15,000$
FV = PV x (1 + i)n
5
15,000 = 10,200 x (1 + i)
15,000/10,200 = (1 + i) 5
1.47 = (1 + i) 5
See in the table 1.47 at year 5, it’ll be 8%
5√
Table
1.47 = (1 + i)
FV = PV x FVIF i%, n
15,000 = 10,200 x FVIF i%, 5
1.47 = FVIF i%, 5
i = 8%
0
??
Equation
PV = FV x 1/(1 + i)n
=28,500 x (1+0.11)3
1
i= 11%
2
3
28,500$
Table
PV = FV x PVIF 11%, 3
=28,500 x 0.7312 = 20,839 $
0
3
10,000
??
7
i=5%
20,000
Calculate both P.V & F.V (Subtraction)
0
i=9%
??
20
20,000
n=30
i=11%
Death rate
PMT
P.V.A ordinary = PMT x PVIFA i% , n
= 20,000 x PVIFA 11%, 30
= 20,000 x 8.6938 = 173,876 (F.V)
PV = FV x PVIF i%, n
PV = 173,876 x PVIF 9%, 20
PV = 173,876 x 0.1784 = 31,019$
0
5
i = 7%
Alternative 1
24,000
FV = PV x FVIF 7%, 5
= 24,000 x 1.4026 = 33,661$
0
1
2
3
4
2,000
4,000
6,000
8,000
10,000
5
Alternative 2
10,000 x FVIFA 7%, 1
8000 x FVIFA 7%, 2
6000 x FVIFA 7%, 3
4000 x FVIFA 7%, 4
2000 x FVIFA 7%, 5
0
1
2
30,000 25,000
3
i = 12%
15,000
PMT
9
10
10,000
30,000 / (1+0.12)1
25,000 / (1+0.12)2
PVA at year 2 /
(1+0.12)2
10,000 / (1+0.12)10
P.V.A ordinary at year 2= PMT x PVIFA 12 % , 7
Compounding Interest More Frequently Than Annually
• Compounding more frequently than once a year results in a higher effective
interest rate because you are earning on interest on interest more frequently.
• As a result, the effective interest rate is greater than the nominal (annual)
interest rate.
• Furthermore, the effective rate of interest will increase the more frequently
interest is compounded.
m → no. of compounding period
n → no. of periods
Annually
Semi-Annually
Quarterly
Monthly
Weekly
Daily
Continuous Compounding
m=1
m=2 / i/m & n x m
m=4
m=12
m=52
m=365
m=∞ / exponential / e i x n e.g. Gold/oil
Let’s assume: Deposit: 100$...Invest in 2 years …i=10%
So if we calculate F.V Annually: F.V = 100 x (1 + 0.1)2 = 121
But if we calculate F.V Semi-Annually: F.V = 100 x (1 + 0.1/2)2 x 2 = 121.55
Semi-annually > Annually
Effective Annual Rate: (Semi-Annually)
EAR = (1 + i/m) m - 1
EAR = (1 + 0.1/2) 2 - 1
= (1.05)2 - 1 = 0.1025 = 10.25 %
Effective Annual Rate > Nominal Annual Rate
n=5
i = 6%
0
1
2
3
4
5
PMT
PMT
PMT
PMT
30,000
F.V.A ordinary = PMT x FVIFA 6% , 5
30,000 = PMT x 5.637
PMT = 30,000/ 5.637 = 5.321$
=
Special Applications of Time Value: Loan Amortization
• Amortization tables are widely used--for home mortgages, auto loans, business
loans, retirement plans, and more. They are very important!
• Financial calculators (and spreadsheets) are great for setting up amortization
tables.
Loan: 6000…i= 10%...n=4 years
0
1
2
3
4
6,000
PMT
PMT
PMT
PMT
P.V. A ordinary
2002
1,250
P.V
Interest
2003
Principle
2004
2005
2006
1,520
F.V
n=4
FV = PV x (1 + g)n
1,520 = 1,250 x (1 + g)4
4
√1520/1250= 1 + g
Lecture 5
Chapter 3
Financial Statements, Cash flows & Taxes
-Free Cash flow is important for firm Valuation.
-In statement of cash flow, we should have (2 comparative balance sheet & 1 income statement).
-Any ↑ in any asset → Cash outflow.
-Any ↓ in any asset → Cash inflow.
-Any ↑ in Liability & Stockholder’s equity → Cash inflow.
-Any ↓ in Liability & Stockholder’s equity → Cash outflow.
-Since we’ve 2 comparative balance sheet: → The beginning of account balance & the ending of account
balance of 2 years.
Dr.
A/R
Sales Revenue
Cash
A/P
Cr.
XX
XX
XX
XX
-If we have ↑ in A/R → Sales on account → so Sales revenue will ↑ → so net income will ↑ → it’s not cash → it is
cash outflow → So it decreases the accrual basis into cash basis.
-Any purchases i.e. A/P → will be included in the C.O.G.S → so net income will ↓
Cash flow Statement
(Purpose: want to know the amount of cash I want to receive from each activity
& amount of cash I want to pay for each activity)
Cash flow from
Operating Activity
Cash flow from
Investing Activity
Cash flow from
Financing Activity
Indirect Method
Net Income: XX
accrual basis → Cash basis
Adjustment to reconcile net income
to net C.F from operating activities
Adjustments:
1) Add back the non-cash expenses
(Depreciation expenses, Amortization expens,….).
2) -Add: loss on sale of non C.A.
-Subtract: gain on sale of non C.A.
3) Check changes for current assets
except for cash.
*∆C.A↑ → outflow
*∆C.A↓ → inflow
4) Check changes for current liabilities.
*∆C.L↑ → inflow
*∆C.L↓ → outflow
1) ∆ in Non-current Assets.
2) Additional information
(Disclosure).
(e.g. you may make changes by
issuing bonds & stocks in exchange
for purchasing lands) → it’ll be
written in the footnote (Note below).
1) ∆ in Long term Debt.
2) ∆ in Stockholder’s equity.
(except R/E).
3) Deduct the Cash
dividends.(because it is distribution
of profit so it is considered cash
outflow)
In Cash flow from operating activity:
Assume:
Purchase equipment: 100,000$
Useful Life: 5 years & Sell it after 2 years.
so, Book Value (B.V) of equipment after 2 years = 100,000 – (2 x 20,000) = 60,000$
Selling
Price
30,000$
70,000$
Loss on Sale: 30,000$
Gain on Sale: 10,000$
-It is investing decisions because it is
equipment (Cash inflow).
-So, the 70,000 will go in investing
activity, and the gain on Sale
(10,000$) will be subtracted from the
operating activity (Net income)
because it is already found in the
operating activity.
Statement of R/E:
-Beginning of R/E
+ Net Income after taxes
(-) Cash dividends (C.S/P.S)
End of R/E
Selling
Price
XX
XX (Net Cash from operating activity) √
(XX) (Deducted from financing activity) √
XX
-It will decrease the net income.
-It will be added in the net income
(Operating activity) because I didn’t
pay for it.
Statement of Cash flow for the year ended Dec. 31st, 2008
**Cash flow from Operating Activity:
Net income
145,000 (It is accrual basis so it has to adjusted to be cash basis)
Adjustment to reconcile
Net income to Cash flow
from operating activities
1) Add: Depreciation expenses
9,000 (It is a non-cash expenses; it is deducted & I’ve to return it again)
2) Add: loss on sale of equipment
3,000 (Also, Check Additional Information no. 4)
(‫)أنا متأكد انى مادفعتهاش‬
3) ∆ in C.A except for Cash
- Add: Dec. in A/R
- Subtract: inc. in Inventory
- Subtract: inc. in prepaid exp.
10,000 (Cash inflow)
(5,000) (Cash outflow)
(4,000) (Cash outflow) i.e. Cash paid in advance
4) ∆ in C.L
- Add: inc. in A/P
16,000 (Cash inflow) (Any inc. in C.L will be Cash inflow as if I borrowed money)
- Subtract: dec. in income tax payable(2,000) (Cash outflow)
Net Cash flow provided by
Operating Activities
172,000
172000 ‫ لكن الكاش فلو من األوبراتينج اكسبنس لوحده‬145000 ‫)أنا كسبان على الورق‬
**Cash flow from Investing Activity:
Purchase of equipment
Purchase of building
Sale of equipment
(25,000) (Cash outflow) (Check Additional Information no. 2)
(120,000) (Cash outflow) (Check Additional Information no. 2)
4,000
(Cash inflow) (Check Additional Information no. 4)
Net Cash flow used by
Investing Activities
(141,000)
(It is a good indicator which mean that the company is investing, but if it was +ve this means that the company is out of
business)
**Cash flow from Financing Activity:
Issuing of C.S
Dividends Payment
20,000 (Cash inflow) (Check Additional Information no. 5)
(29,000) (Cash outflow) (Check Additional Information no. 1)
Net Cash flow used by
Financing Activities
(9,000)
***Net Change in Cash: (172,000 – 141,000 – 9000) = 22,000$
Beginning Cash Balance (2007)
= 33,000$
End Cash Balance (2008)
= 55,000$
**Note: Issued 110,000$ long term bond for purchasing land
**(Redemption of bonds → a cash outflow)
What is free cash flow (FCF)? Why is it important?
• FCF is the amount of cash available from operations for distribution to all investors (including
stockholders and debt holders) after making the necessary investments to support operations.
• A company’s value depends upon the amount of FCF it can generate.
What are the five uses of FCF? (Exam)
1. Pay interest on debt.
Both are paid to debt holder
2. Pay back principal on debt.
3. Pay dividends.
4. Buy back stock. (e.g. Treasury Stock)
5. Buy non-operating assets (e.g., marketable securities, investments in other companies, etc.).
What are operating current assets?
Operating current assets are the CA needed to support operations.
–Op CA include: cash, inventory, receivables.
–Op CA exclude: short-term investments, because these are not a part of operations.
Calculate the Operating C. A (10,000)
(exclude marketable securities)
Cash
Inventory
A/R
Calculate the Operating C. L (8,000)
(exclude Notes Payable ‫)الكمبياالت‬
A/P
Accurals
Anything Payable
Net Operating working Capital (NOWC) = Operating CA – Operating C.L = 2,000
Total net operating capital (also called operating capital)
Operating Capital= NOWC + Net fixed assets.
– Operating Capital 2007 = $1,317,842 + $939,790 = $2,257,632. (Actual)
– Operating Capital 2006 = $1,138,600.
(Anticipated)
Net Operating Profit after Taxes (NOPAT)
NOPAT = EBIT (1 - Tax rate)
(Operating profit x (1-Tax))
Free Cash Flow (FCF) for 2007
FCF = NOPAT - Net investment in Operating capital
= $10,464 - ($2,257,632 - $1,138,600)
= $10,464 - $1,119,032 = -$1,108,568. (Deficit)
Return on Invested Capital (ROIC)
ROIC = NOPAT / operating capital
ROIC07 = $10,464 / $2,257,632 = 0.5%.
ROIC06 = 11.0%